1. At the end of September, its two-year interest rate rose up to more than 70%.

2. Greek default is increasingly anticipated by markets – an expectation that is partly self-fulfilling; and

3. Default may not solve all of Greece’s problems, since private investors may be reluctant to buy some Greek debt
in the future.

Yet, taking default anticipations into account, there is a simple mechanism that could help. It would reassure private investors and give Greece the opportunity of implementing structural reforms – thus allowing expectations to be based on the reforms rather than self-fulfilling prophecies.

The problem with default is that all private debt holders are likely to be penalised, including the ones that would trust Greece and buy some newly issued debt. If all private investors are penalised when default happens, then all potential private investors may be reluctant to lend in the future.

Priority to new investors

The simple mechanism is to establish a debtors’ hierarchy. Greece should pass a law stating that all investors, starting from now, will have priority in case of default, compared to “old” private investors. Given the average maturity of Greek debt and the fact that the rate of default is unlikely to be stronger than 50%[1], it should take some time before the volume of new emissions is considered as problematic once again.

Which guarantee to bring?

Of course, this mechanism would have to be credible to be effective. That raises the question of which guarantees to provide. In fact, there would be two guarantees:

First, Greece, unlike households or firms, is a state and has some specific resources, mainly fiscal. That is indeed an important privilege, but it is not sufficient given current market conditions.

All non-private investors that have priority for reimbursement in case of default will accept sharing this priority with new private investors.

The level of this priority would remain to be defined, but the priority would be at least as important as the lowest one among non-private investors. To give more credibility to this mechanism, these non-private investors (IMF, ECB, European Financial Stability Facility, etc.) may be given the right to declare at any time the end of this shared priority if they assess that Greece reimbursement capacity is endangered again. Of course, it would not be possible to do it on a retroactive basis.

This would diminish the risk of moral hazard since Greece would still have the “sword of Damocles” of the end of this mechanism that may happen at any time. On the other hand, non-private investors would not be tempted to be too lenient to Greece since they would also be partly non-reimbursed if the priority was too widely awarded.

A win-win strategy, even for “old” Greek debt holders

This mechanism would enable Greece to postpone default at a lower cost for “old” investors[2], which would make it more acceptable for countries whose financial institutions are much concerned with Greek debt, and may alleviate the current crisis. Indeed, if this mechanism is efficient and enables Greece to save money on debt service, then a part of this benefit could be used to set a default on a basis which would diminish over time (for instance, if default takes place in one year instead of now, the rate of default would be 45% over “old” debt instead of 50%. Of course, it may be possible to vary this advantage depending on the characteristics of these “old” investors such as by maturity – the moment when the investment took place).

This would not be the end of the story

Of course, to be efficient and credible over time, Greece will have to implement structural reforms and other European countries will have to find a lasting institutional solution to cohesion problems. The proposed mechanism is a means to minimise the impact of a default and provide some breathing space. While that would only be a first step, time is running out for Greece and Europe.

This figure has been taken as a reference, but it could be somewhat different. Some economists have for instance proposed some mechanisms to settle a default on a 50% basis (see: “L’appel des economists français et allemands pour sauver l’euro”, in Les Echos, 26th September 2011).

Not benefiting from shared priority, “old” private investors may be tempted to sell Greek bonds (or try to), and there may be two Greek debt markets, instead of one. This is not necessarily a problem since the focus for Greece is for new issues. Nevertheless, to limit the confusion and the risk of contagion, this “old” market should be given some incentives to hold.